1. Field of the Invention
The present invention relates to a system, method and means for pricing and trading short-term derivative instruments known as ‘short-term option contracts’ or ‘micro-options’ on the financial markets, commodity markets, foreign exchange markets or other types of commercial or retail marketplaces.
2. Background to the Art
An option contract is a derivative contract that conveys to its buyer or holder the right to take possession and ownership upon expiry or before expiry of shares, stock or commodities of an underlying good, service, security, commodity, or market index at a specified price, or strike price, on or before a given date (the expiration date). For purposes of convenience in this description, the term ‘underlying goods’ will be used to collectively and generically refer to these elements, without limiting the discussion specifically to a traditional material that one would call goods. The seller of the option grants this right to the buyer, usually at a specific price or cost. The seller of the option receives the premium paid by the buyer, but the seller must incur the risk of delivering the underlying instrument upon exercise of the option contract by a call buyer, or taking delivery of the underlying security upon exercise if a put seller. Option contracts are traded for a premium, which can be any price the buyer and the seller agree upon as being reasonable. Options are either calls (right to buy) or puts (right to sell). Herein, the term “underlying”, “underlying instrument”, “underlying good”, “underlying security” or “underlying commodity” will be used when referring to the underlying existence and terms of an option contract, but it should be understood that these terms within the scope of this description can refer to any good, service, security, commodity, market index or other purchasable or tradable item of value or other asset.
Upon expiry, long option contracts are normally either exercised into a designated underlying instrument, abandoned or cash settled. This means that the buyer of a call option can opt to take possession of the underlying goods through exercising the buyer's right to buy the underlying goods or security at the designated strike price of the option. In some situations the buyer of an option can receive a cash payment upon exercising the option, the cash payment being equivalent to the difference between the strike price and an index price. This can occur, for example, in the case of a stock index option where the underlying goods do not represent a deliverable security. Some options allow the exercise of the option only at expiration (European options) while other options allow exercise anytime during the life of the option (American options). Typically, except in the case of a stock split or other circumstance that alters the composition of the option due to a change in the underlying instrument's standardized parameters, an option contract represents the option to buy or sell a specific number (e.g., 100) of shares of the underlying goods or security.
Option trading has been in existence for thousands of years. The Greeks, Romans and Phoenicians used options to insure merchandise shipments. 2500 years ago, Aristotle wrote about a Greek philosopher Thales who bought options on olive presses when he expected there to be a large olive harvest in the following season. In a publication entitled The Confusion of Confusion, written in 1688 in Spain, Don Jose de la Vega described an options contract, indicating that option contracts were traded on the Amsterdam Bourse as early as the 17th century. Option contracts were in common use throughout the world by the 19th century.
In America, the Put and Call Brokers and Dealers Association was formed in 1935 with 20 members who did most of the option writing in the country. These options were traded only in over-the-counter (OTC) markets and were traded informally on an as-needed basis. In an OTC options market, buyers indicate to their potential counter parties their exact requirements on strike price, expiration date and quantity of the underlying goods, and then the counter parties quote a premium for that option. OTC trades are transacted bilaterally between counter parties without the involvement of centralized exchanges or centralized clearing. As such, there is typically a higher degree of credit risk associated with an OTC trade and therefore preliminary negotiations may be needed to establish credit worthiness before buyer and the seller reach an agreement to trade.
Over-the-counter markets are in use today in various underlying instruments by clearing banks, investment banks, currency exchanges and brokerages, and because transactions are normally bilateral and confidential, the exact size and scope of the OTC market is not known. Some estimates are that the OTC options markets represent the largest segment of options trading today, though other estimates are not so optimistic. OTC bulletin board services are currently in use to facilitate OTC negotiations and trading. These services post dealer (member) quotations on the bulletin board for a service fee, and allow other dealers (members) to access the quotations in order to complete an OTC trade in a manner that is independent of the bulletin board service. As such, these OTC bulletin boards are not operating to match, clear or settle the transactions of the subscribing members. The bulletin boards therefore fall under a different regulatory classification than do exchanges that satisfy the criteria laid down by the Commodity Futures Modernization Act of 2000 or The Commodity Exchange Act, by performing centralized order management and order matching services leading to clearing and settlement.
In 1973, the Chicago Board Options Exchange (CBOE) was formed to facilitate the trading of standardized equity options in a non-OTC environment. The exchange created options with standardized strike prices, a standard number of shares per contract, and standard expiration dates, which left only the option price (premium) to be negotiated on the open market. The Options Clearing Corporation (OCC), also formed in 1973, acts as counter party to both buyer and seller in all exchange-based, non-OTC options trading. The current U.S. equity options exchanges own an interest in the OCC and benefit from the guarantee it provides for daily transactions between anonymous counterparts and subsequent contract fulfillment upon exercise.
Although there may be minor differences in some procedures on each of the exchanges, they are beginning to take advantage of electronic methods of trading to reduce their reliance on a method of floor trading known as “open outcry.” In “open outcry” marketplaces, trading takes place through the use of hand signals and oral communication between market professionals at a central location referred to as a “pit” in open view of other market professionals. In the pit-based system, an order is typically relayed to a trader standing in a “pit” by a booth broker who solicits options business directly from clients standing in a booth on the trading floor. Once the pit trader has received an order from his booth broker he makes the order known to the pit crowd and waits until another trader (or traders) shouts back a two-sided bid and offer market (the prices at which they are willing to buy and sell a particular number of option contracts). Then if the terms of the pit bid and offer are acceptable, a trade may occur.
All option markets, floor-based and electronic, rely on the skills of market professionals, known as specialists or market makers, who are responsible for maintaining an orderly market and providing liquidity through the publishing of bid and offer spreads. In floor-based markets, specialists can buy and sell on behalf of customers for orders that cannot be immediately processed, such as limit or stop orders, or they can buy and sell for their own account, which, in turn, provides liquidity in the market. Electronic markets divide these functions into two distinct roles, one being the market maker who provides liquidity through quoting and the other being the exchange administered limit order book that keeps track of limit, stop and other unfilled orders.
Market makers fulfill their responsibility for providing liquidity by ensuring that there is a two-sided market by publishing quotes electronically or calling out prices (quotations) at which they are both willing to buy (bid) and sell (offer) a particular option contract in the open outcry pit. Market makers honor their quotations when trading with incoming orders. In the traditional open outcry system, market makers call out these quotations throughout the trading day and, in addition, when orders are routed into the trading pit.
Over time, each of the existing option exchanges has developed systems to track and publish the best price quotation for each of their traded products. In the case of open outcry markets, market makers call out quotations that are manually entered into a tracking system by an exchange official. The system tracks and displays the best bid and best offer, as well as the market depth, for the prices quoted in the trading pit at any given time. In their existing state, these quotation systems do not identify the best quotation currently displayed or the number of contracts (size) for which the market maker is willing to trade. In some cases these systems simply display a single quotation for the entire pit that is valid (firm) for only smaller-sized orders, for example 10 contracts, and for only certain types of orders, for example public customer orders entered on an exchange for immediate execution at the existing market price (the best bid or offer). Such customer-entered orders are known as “market orders.”
Some floor-based exchanges have procedures for the automatic execution and allocation of these smaller-sized public customer market orders at the displayed quotations through a rotation assignment of the orders among the pit market makers known, for example, at the CBOE as the RAES “wheel.”
Execution through the use of RAES and the displayed quotation and automatic allocation to market makers does not provide a guaranteed market for incoming smaller-sized public customer market orders unless the incoming orders reflect the best bid or offer in the market at the time. The rotation system is a ‘value added’ for the market maker who is able to count on a dependable level of retail business all throughout the trading day. CBOE market makers providing quotes on RAES also quote prices in the pits.
When a limit order cannot be filled immediately, either because the current bid or offer quotation is outside the market or because there is inadequate size to fill the order at the volume ordered, the order is placed into a “limit order book”. A limit order book is a record of outstanding current public customer limit orders that may be matched against future incoming orders. At the existing option exchanges, these limit books may be maintained in a manual and/or electronic format.
Beyond the trading processes internal to each option exchange, additional considerations arise when an option is listed on multiple exchanges. In order to assure that an order in a multiply-listed contract receives the best execution price, market professionals at an originating exchange are charged with the responsibility of checking the other exchanges' quotations for prices better than the originating exchange's best bid or best offer and with the responsibility of contacting the other exchange to verify that the quotations are valid. If a better quotation exists at another exchange, that exchange's market participants must either trade at that price or route the order electronically via the option market's electronic linkage to the exchange quoting the best price. The incoming order into a non-electronic exchange is generally not automatically processed and must be addressed on a case-by-case basis. The increasing volume of trades in option contracts, as well as the speed at which underlying price information is transmitted to consumers, has increased the demand for faster trade execution in today's market.
Computer-based exchange systems have been used for a number of years to manage a central limit order book, match orders and record fills in all forms of commodities, stocks and options. In an electronic exchange environment prices in options are relayed electronically to customer sites where computer workstations now house front-end trading software that enables market professionals to manage orders in commodities, securities, securities options, futures contracts and futures options among other instruments. Within the front-end trading system environment at the client side is a range of functionality that enables a customer to selectively display his own order information to send orders directly to the exchange back end, and to receive information relating to filled orders from the exchange.
Since 1973, apart from the Chicago Board Options Exchange, eight other exchanges have offered standardized equity options trading. These are the American Stock Exchange (AMEX), the NASDAQ, the New York Stock Exchange (NYSE), the Pacific Stock Exchange (PSE), the Mid West Stock Exchange (Chicago Stock Exchange), the International Securities Exchange (ISE), the Boston Options Exchange (BOX) and the Philadelphia Stock Exchange (PHLX). All these exchanges list options with standard strikes, standard numbers of shares per contract and standard expiration dates. On May 26th, 2000, the International Securities Exchange (ISE) formed the first fully electronic U.S. options exchange followed by the Boston Options Exchange (BOX) on Feb. 6th, 2004. Since their inauguration, the ISE and BOX have positioned themselves as electronic competitors to the conventional open outcry option exchanges and, combined, have quickly grown to surpass the trading volume of the CBOE for equity stock options.
Option contracts have also been used to give incentives to employees of companies. For many years, publicly owned companies have provided payment to upper level executives in the form of options to purchase shares of stock in the company for whom they were employed at discounts from the prevailing market price. These stock options are attractive for many reasons. For one, the option is a form of deferred payment that provides certain tax benefits and allows the individual to control the times during which the income is derived. In addition, the opportunity to buy stock in the company is an additional incentive to the option recipient to work to increase the value of the company, and so also the value of the stock options.
Early forms of option plans were limited in scope and available only to a handful of key executives. Indeed, the use of options as a form of compensation was routinely limited to the officers of a corporation, while the remaining employees were either granted stock pursuant to pension plans or, more often than not, were unable to participate in company sponsored ownership. As alternative forms of compensation grew in popularity, companies were increasingly interested in providing payment to select employees in untraditional forms. Concepts such as flex time, position sharing, benefit tailoring, and others became the terminology of personnel departments for mechanisms to address staffing needs in a cost efficient manner.
More recently, companies are examining the possible broader use of stock option-based compensation to cover greater numbers of employees in order to stretch out staffing dollars and to provide remuneration to employees in a form particularly desired by many staff members. Although greeted with substantial enthusiasm, the problems in implementing a company sponsored stock option plan are daunting. As the number of participants grows, tracking salient data becomes increasingly complex. For the most part, companies are not equipped to handle the transactional attributes of stock option processing on a scale above a handful of participants. Each of the options (or each block of options) for each grant to each participant in the plan must be individually tracked for proper delineation of such parameters as the granting, vesting, exercise, and expiration dates, and the particular strike price for which the option right was granted. Also, the practical exercise of an option requires the use of a brokerage house and an established exchange for trading and consummating the options and the underlying security in accordance with the plan attributes.
The complexities of option account processing increase disproportionately when more than one company is involved; this is especially true for multinational companies working within the borders of multiple countries, each with its own set of legal requirements on stock ownership and tax consequences for resident employees. Heretofore, there has been an absence of processing capabilities available to address the management of a multi-country, multi-company stock option account compensation plan for a plurality of individual accounts. In addition, stock option plans for multinational corporations, or for multinational employees (i.e., employees who work for one or more companies in two or more countries), have the added practical problem of exercising options where the underlying security and the funds are in different currencies.
Besides currency differences, from the participant's point of view there can be significant uncertainties over how to exercise options because options may be granted in qualified (i.e., qualifying for preferential tax treatment) or non-qualified plans, and the option may be exercised so that the participant receives the underlying security, a cash disbursement representing essentially (less taxes, commissions, and fees) the difference between the strike price and the then present market price of the underlying security, or some combination thereof. It would be beneficial to the participant if he or she could simulate various financial outcomes (e.g., including estimated taxes, fees, or cash disbursements, or combinations thereof) to arrive at what is best for the participants' financial needs precipitating exercise of the options.
In 1973, the Black-Scholes pricing model for exchange-traded options was published by Myron Scholes and Fisher Black. Using the Black-Scholes model, the price of a call option can be expressed using the following formula:
      C    =                  PN        ⁡                  (                      d            1                    )                    -              X        ⁢                                  ⁢                  ⅇ                      -            rt                          ⁢                  N          ⁡                      (                          d              2                        )                                          d      1        =                            ln          ⁡                      (                          P              X                        )                          +                              (                          r              +                                                s                  2                                2                                      )                    ⁢          t                            s        ⁢                  t                                d      2        =                  d        1            -              s        ⁢                  t                                    Where:                    C=the price for the call option            P=the current price of the underlying security            X=the exercise price for the option            r=the risk free interest rate            s=standard deviation of the underlying returns            t=time left until the option expires            N( )=cumulative standard normal distribution            d1 and d2=the normalization factors of the option                        
This formula was the first theoretical model for calculating the fair value of a call option, and Black and Scholes were awarded the 1997 Nobel Prize in Economics over twenty years after the model was first published. Today the Black-Scholes formula is in use daily by thousands of traders to value option contracts traded in markets around the world.
The Black-Scholes pricing formula, along with other theoretical option pricing models, calculates the fair value of an option in part by assuming that fair value will be the price someone would pay in order to break even in the long run. The model employs several parameters that can affect the value of an option, the most important of which are the price difference between the underlying instrument and the strike price of the option, the volatility of the underlying instrument's return, and the time to expiration of the option.
There are many variations of the standard “vanilla” call option that the Black-Scholes pricing model is based on. Some of the more interesting and important ones are listed below:                Forward-Start Option. An option that starts proportionally in or out of the money after a known elapsed time in the future.        Option on Option. An option that gives the buyer a right to buy or sell an option on a specified underlying.        Accrual Option. An option that gives the buyer the right to receive a payoff for each day the underlying exceeds the strike price of the option.        Extendible Option. An option that may be exercised at its original expiry date but can also be extended at the holder's discretion. The strike price may also be adjusted at the time of the extension.        Analytic Spread Option. An option on a spread (or difference) between two different underlying instruments.        Barrier Option. An option that depends on whether the price of the underlying instrument has reached or exceeded a certain price.        Partial Start Barrier Option. The location of the monitoring period of the option starting at the starting date and ending at an arbitrary date before the expiration of the option.        Chooser Option. Gives the buyer the right to choose whether the option is to be a call or a put at the decision time of the option.        Cash Settled Option. A standard option except that the payoff is in cash by the amount the option is in the money at expiration. The buyer does not need to ‘buy’ the underlying security.        Fixed Strike Lookback Option. At expiration the option pays out the maximum of the difference between the highest observed price in the life of the option and the strike price.        Floating Strike Lookback Option. Gives the holder of the option the right to buy the underlying security at the lowest price observed in the lifetime of the option.        Binary Option. An option on whether an event occurs or does not occur, at expiration, settled for either a fixed price or worthless if the event does not occur.        
The Chicago Board Options Exchange started offering flexible exchange options (FLEX options) as a type of tradable derivative in 1993. With FLEX options the user can select customizable contract terms, and once a custom contract has been selected and there is open interest in that contract, the exchange will continue to trade contracts with those identical terms as a series until the expiration time of the custom option. With FLEX options, the terms of the contract that can be customized are the contract type (calls or puts), expiration date (with certain exceptions), exercise style (American or European), exercise price and contract size. When a user selects a new custom contract, a Request for Quote (RFQ) is entered into the system and market makers will respond with a quote for that contract. Once there is open interest in a certain contract, that contract will be traded until expiration of the option, with certain limits on contract sizes. FLEX options give the user the advantage of customizable terms and an available secondary market for resale of purchased options to close out positions before expiration.
Combinations of economic transactions using options can sometimes result in interesting positions in the underlying market. For example, a bull call spread is a well-known option combination that involves buying a call option and selling a call option with a higher strike price where both activities have the same expiration date. This combination of events has the effect of limiting gain and loss if the underlying stock or commodity moves a large amount from its original price at the time the spread was created. However, the open spread position will still be moderately profitable with a moderate price gain in the underlying security. A bear call spread is the opposite of a bull call spread, where the call that is sold has the same expiration date but a strike price lower than the call that is bought. The net effect is the same, except the position is profitable in the case of a limited price drop instead of a price gain.
Another type of option combination is a time spread (or calendar spread). A time call spread is similar to the bull call spread or the bear call spread in that calls are both bought and sold, but the options that are bought and sold in this case have the same strike price but differing expiration dates. A long time call spread is entered by purchasing a call and selling a call with the same strike price but different expiration dates. The short option will expire first, and it is at this expiration time where the position typically has its highest value. It can be noted that although call spreads were discussed here, similar effects can be had using puts instead of calls, and the strategies do not differ substantially with the exception of the direction of profitability with underlying price movement.
Another type of option position is the synthetic long or the synthetic short position. A synthetic long position is created by buying a call of a particular strike price and expiration, and simultaneously selling a put with the same strike and expiration. The profit/loss effect of this trade with respect to the underlying good's or security's price movement is the same as buying the underlying instrument—there is no difference, aside from the price of the position, to simply owning the underlying security. This can be seen by considering the following: if the synthetic long position is entered with a strike price of 30, and if the underlying price moves above 30, the trader will want to exercise the call to buy the underlying instrument at the strike price. Conversely, if the underlying price moves below 30, the call becomes worthless, but the buyer of the put (on the other side of the trade) will undoubtedly want to exercise the put, which obligates the trader to buy at the strike price of 30. In either case, once the options expire, the trader ends up buying the underlying instrument at the strike price for a synthetic long position, or selling the underlying instrument at the strike price for a synthetic short position.
In both the synthetic long position and the synthetic short position, it is rare for the underlying security to trade exactly at the strike price when the option position is purchased, and as a result the premium for the option bought will usually differ, sometimes substantially, from the premium for the option sold. This means that although the premiums may largely cancel each other out (premium sold canceling premium bought in terms of cash out-of-pocket), there may be a residual debit or credit to the trader's brokerage account due to the inequality. In addition, arbitrage opportunity may be present if the difference in premium for the options plus the strike price does not equal the price of the underlying instrument.
There are many other types of options positions that can be entered into, some involving a combination of different options. The various types of position that can be created are too numerous to cover individually, but it should be noted that each position has its own risk/reward profile and profit/loss expectancy. Depending on the trader's perception of the market and the price behavior of the underlying security, an appropriate option strategy can be selected, enabling the trader to customize his option portfolio according to his needs. This flexibility creates an important advantage in the trading of options as opposed to directly buying or selling combinations of the underlying instrument.
Option traders sometimes refer to a mathematical way of defining option contract properties as determining “the Greeks.” There are five important “Greek” values that are well known in the industry; the Delta, the Vega, the Theta, the Rho and the Gamma. The delta of an open option position is the amount that the option's price will change in accordance with a one-point change in the price of the underlying. Vega is a measure of the option's sensitivity to volatility. Theta gives the sensitivity to time-to-expiration. Rho and gamma give the option price sensitivity to interest rates and the amount of change in the delta for a small change in the underlying instrument, respectively. Each of these parameters is a measure of the sensitivity of the option's price to changes in the underlying instrument. Each is an important measure of option price sensitivity.
Futures contracts, like option contracts, also have an underlying security, commodity, good or service. The buyer of a futures contract agrees to accept delivery of the underlying on the expiration date of the contract, and the seller of the futures contract agrees to deliver the underlying at expiration. Futures contracts, unlike their underlying instruments that have limited availability, can be infinitely replicated with opposing positions having the effect of canceling and negating each other. Unlike option contracts, futures contracts do not have a strike price and as such, the value of a futures contract will typically be formed on the basis difference to the price of the underlying instrument.
Forward contracts on an underlying instrument are contracts that mature at a certain date and time but for which settlement (the actual transfer of ownership of the underlying instrument) takes place at a separate and distinct time in the future. Forward contracts do not have the same flexibility as futures contracts and are not readily transferable in a secondary market. They often represent a transaction effected between two consenting counter parties as a bilateral trade. They are considered to be “over the counter” (OTC) in nature and are not bound by the standardized conditions of exchange traded futures or options.
Contracts for differences (CFD), traded in the UK, allow traders to “buy” a security at its current price, and when the contract is sold, the difference in price is cash settled. Traders may choose how much they wish to pay, i.e., there is no actual transfer of assets involved. A broker will typically offer a point spread and a trader will “buy” at the higher value, the “ask”, and “sell” at the lower value, the “bid.” The process is very similar to financial spread betting, also available in the UK. The main difference between CFDs and financial spread betting is the tax treatment preference given to CFDs. The advantages of a CFD are that market participants can choose their buy-in price, and they provide a leveraged investment vehicle. The disadvantages of CFDs include potentially losing much more that was risked.